Analyzing the Effectiveness of Fiscal Policy in Economic Stabilization

This essay discusses the role of fiscal policy in stabilizing a nation’s economy, focusing on overcoming recessions and controlling inflation through discretionary and non-discretionary measures. It explains how governments use increased expenditure and tax reductions to stimulate aggregate demand during recessions, and conversely, reduce expenditure and raise taxes to curb inflation. The essay also examines the United Kingdom's fiscal policy response to the 2008-2009 recession, including tax cuts and investment schemes, and assesses the limited effectiveness of these measures due to high debt levels among firms, consumers, and banks, which led to increased saving rather than investment. The paper concludes that while the UK adopted fiscal policy, the specific measures were not entirely successful in facilitating a full recovery.

FISCAL POLICY ROLE IN ECONOMY STABILIZATION AND ITS EFFECTIVENESS 1
FISCAL POLICY ROLE IN ECONOMY STABILIZATION AND ITS EFFECTIVENESS
Student Name
Institutional Affiliation
Facilitator
Course
Date

FISCAL POLICY ROLE IN ECONOMY STABILIZATION AND ITS EFFECTIVENESS 2
Discussion
Fiscal policy refers to a means of controlling the economy of a given nation by its government.
The nation’s government adjusts its level of expenditure and the prevailing tax rates in its
economy in order to monitor and also influence the performance of the economy. Therefore,
fiscal policy is a very crucial instrument in stabilizing a nation’s economy. A given economy is
said to be stable if the recession is overcome and the prevailing inflation level in the economy
controlled accordingly (inflation kept stable and at the lowest rate possible). Generally, there are
two types of fiscal policies namely the discretionary and non-discretionary fiscal policies
(Easterly and Rebelo 2014, p.417). Discretionary fiscal policy aims at influencing a nation’s total
output and the general price for goods and services. It mainly aims at manipulating the aggregate
demand for goods and services within the nation. Non-discretionary fiscal policy aims at
automatically raising the aggregate demand when a recession occurs and lowering aggregate
demand in case inflation rises in the economy. This is made possible through the automatic built-
in tax and expenditure mechanism without deliberate actions by a nation’s government.
The most commonly used fiscal policy by various governments is the discretionary fiscal policy.
The discretionary fiscal policy can be tailored to expand or contract some key economic
performance indicators such as inflation to achieve the desired economic measures. During the
recession period, the economy of a given nation is said to be experiencing decreased aggregate
demand as the nation’s investment falls. This is due to the fact that many investors are
pessimistic about the future as far as profit making is concerned. This, therefore, makes the
overall marginal efficiency of investment to decline leading to the creation of a recessionary gap
in the economy as the aggregate demand curve shifts downwards. The government can overcome

FISCAL POLICY ROLE IN ECONOMY STABILIZATION AND ITS EFFECTIVENESS 3
this by adopting two ways namely the increase in its expenditure and the reduction of taxes. The
government increases its expenditure by coming up with various public works such as the
construction of roads, ports, and dams among others. All these activities increase the final output
in the economy and also create jobs reducing unemployment. As more people are employed,
income to spend on consumer goods is available and as a result, the aggregate demand in the
economy increases enabling it to overcome recession. Reduction of taxes is an alternative fiscal
policy measure to expand the economy and enable it to overcome recession. When taxes are
reduced, consumers in the economy are left with more disposable income and as a result, the
overall consumption in the economy increases leading to an increase in the economy’s aggregate
demand.
Fiscal policy is also used to control inflation in a given economy by reducing expenditure by the
government and increasing tax rates. When the government reduces its expenditure in the
economy in sectors such as defense and subsidization among others, it creates a surplus in its
budget. This reduces the aggregate demand in the economy as income available for consumption
is reduced. Increase in taxes especially personal direct taxes such as corporate, wealth and
income taxes reduces the available disposable income to consumers. As a result, the aggregate
demand decreases as consumers have little to spend. The decrease in the aggregate demand helps
in reducing the general price for goods and services in the economy and hence reduces inflation.
The United Kingdom was among the nations in the Europe region which were highly affected by
the 2008-2009 great recession. The nation, therefore, adopted various fiscal measures to
overcome the great recession (Cloyne 2013, p.1507). Various tax cuts were introduced in order
to avail more disposable income to consumers and increase aggregate demand in the economy. A

FISCAL POLICY ROLE IN ECONOMY STABILIZATION AND ITS EFFECTIVENESS 4
tax cut of £145 for basic rate (for earnings below £34,800 per year for the taxpayers) and Value
Added Tax cut of 2.5 percent was also introduced. The government of the United Kingdom also
introduced an expenditure of £3 billion for investment and some other measures such as the
Small Enterprise Loan Guarantee Scheme of £20 billion. The adopted fiscal policy by the United
Kingdom did not efficiently enable the economy from recovering from the recession. The United
Kingdom firms, consumers and banks had high debt. The bank bail-outs had a significant debt on
the public finances. As a result, the United Kingdom deficit rose to £175 billion. As banks,
consumers and firms decided to settle their debts first, the overall spending in the economy
declined. Much of saving was observed rather than investment. In a nutshell, the United
Kingdom adopted the fiscal policy to overcome the 2008-2009 great recession but the measures
are taken were not so effective and hence did not properly overcome the recession.
References
Cloyne, J., 2013. Discretionary tax changes and the macroeconomy: new narrative evidence from
the United Kingdom. American Economic Review, 103(4), pp.1507-28.
Easterly, W. and Rebelo, S., 2014. Fiscal policy and economic growth. Journal of monetary
economics, 32(3), pp.417-458.